Using life insurance to leave your kids an inheritance

Like a reverse mortgage, you would borrow against the policy’s cash value. When you pass away, the loan is paid off with the tax-free life insurance death benefit and the remaining insurance is paid out to your children tax-free. Here’s how it can work.

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Q. My wife and I are both 57 years old. I have a business in Ontario, from which I earn $260,000 a year, and my wife makes $40,000 at her job. We have maxed out our RRSP contributions and we will soon do the same with our TFSAs. We are not big spenders and I want to leave our kids some money. On the advice of my accountant, I set up a holding company so I can pay myself a salary of $150,000 and I put the rest of my annual income in the holding company. Someone has suggested that a life insurance policy in my holding company would be a good investment. Is that a good idea?
–Aaron and Cynthia

A. At your stage of the game, life insurance is all about tax. So you may want to know more about an insurance concept often referred to as the “corporate insured retirement plan” which is all about reducing tax and maximizing the transfer value of your wealth to your children.

The basic concept is to buy a permanent insurance policy (not a term policy) in your corporation. Then, like a reverse mortgage, borrow against the policy’s cash value and pay yourself a taxable dividend from your corporation. When you pass away, the loan is paid off with the tax-free life insurance death benefit and the remaining insurance is paid out of your corporation to your children (shareholders) tax-free.

This concept is best suited to conservative or moderate-risk investors who have maximized their Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs). This strategy will likely not appeal to an aggressive investor who plans to hold only non-dividend paying stocks in their portfolio throughout their lifetime.

To really understand how this works and visualize the benefits, you need to understand the tax behind the strategy.

Tax impact

With your corporation, you can decide on the amount you want to pay yourself and the amount you would like to leave in your corporation.

In your case, if you pay yourself a salary of $150,000, you will pay tax of $45,413, leaving you with $104,587.

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Now here is the important part: What happens to the $110,000 ($260,00 – $150,000) you’re leaving in the holding company?

In Ontario, the small business tax rate is 12.2%, so on $110,000, your company will only pay tax of $13,420, leaving you with $96,580 to invest.

Bottom line: You will pay $41,167 less tax by splitting your income between your personal income and your holding company. Sure, you’ll have to pay some tax when you eventually draw dividends from your corporation, unless, of course, the accumulation of your $41,167 tax savings leaves your corporation as a tax-free dividend created by a tax-free life insurance death benefit.

Investing in your holding company

If you continue working for the next 10 years at your current income, $96,580 per year will be available to invest within your holding company. You can invest all of this money or you can divide it between an investment portfolio and a life insurance policy.

The challenge that comes with investing within a corporation is that your investment earnings are taxed at the highest marginal tax rate. In Ontario, that means interest is taxed a 53.53%, eligible dividends at 39.34% and capital gains at 26.76%. So, if you have a $100,000 GIC earning 2.2%, you will earn $2,200 minus 53.53% for tax = $1,023. The after-tax return on that GIC is 1%. (Ouch!) That is why it makes sense to avoid, as much as possible, investments with some form of distribution.

One solution is to purchase an insurance policy that allows you to accumulate funds (cash value) within the policy. Once the money is in the policy the cash values grow tax-deferred and upon death, the insurance proceeds pay out tax-free, and in most cases can be paid tax-free out of your corporation.

Does the plan really work?

This all sounds good on paper, but does it really work? To simplify things and help you make a good decision, I have modelled your situation and run a few different comparisons. You can view the outcome in this video.

To model this out I have made the following assumptions:

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You have an investment portfolio made up of 60% stocks and 40% bonds, earning a total return of 4.1% after fees.

You purchase a whole life insurance policy from which the death benefit pays out when you have both passed away. The premiums are set at $40,000 a year for 10 years, and then you will stop making premium payments. The death benefit will start at $477,000 and grow over time.

In year 11 you will borrow $23,167 against the insurance cash value and pay yourself a dividend of $23,167 each until you both pass away at age 90. The interest rate on the loan is 5%, which will be paid off with the life insurance death benefit.

If you are an aggressive investor, I’ve included a solution with an investment portfolio made up only of stocks, with some dividend and capital gains income, earning 5.58% after fees.

Finally, I thought that if the insurance is going to take the place of your bond portfolio, then maybe the remaining money could all be invested in a stock portfolio, so I also ran this solution.

The table below summarizes the results for the year 2054, when your wealth has transferred to your children. All of your personal assets have been taxed but I have not calculated the after-tax value of the investments in the corporation. This is because the corporate investments will not be taxed until your children decide when and how they would like to draw the money.

The important thing to note is that there is more money available to come out of your corporation tax-free with the insurance concept than without.

No insurance

60/40 portfolio

4.1% return after fees

With insurance

60/40 portfolio

4.1% return after fees

No Insurance

100% stock portfolio

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5.58% return after fees

With insurance

100% stock portfolio

5.58% return after fees

Pre-tax transfer value to children + personal after-tax estate value

$6,036,118

$6,741,198

$7,886,988

$8,343,044

Aaron and Cynthia, based on the results shown in the table above and the accompanying video I created for you, the corporate insured retirement plan may work for you. Note that I based the insurance cash value returns on the current dividend scale of a large Canadian insurance company, and rates can change. If you would like to learn more about this strategy, talk to an advisor or insurance professional, as I don’t recommend this as a DIY strategy.

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